Smart Beta: Just a Fancy Marketing Term?

Smart beta—or alternative beta, as some call it—is getting a lot of attention from investors and advisors these days, and many fund managers are launching new strategies in this area. These funds weight holdings in unconventional ways, aside from market capitalization. But Rick Ferri, founder of Portfolio Solutions, thinks “smart beta” is a clever marketing term, but we don’t know whether it is in fact “smart.” We do know that these strategies have outperformed over the last 15 years.

“Whether it will outperform over the next 15 years, that’s the question,” Ferri said during a session at the 2014 Morningstar Investment Conference in Chicago this morning.

“Nothing fails like success on Wall Street,” Ferri said. He’s referring to the phenomenon where investors flood into a popular strategy, and the benefits of that strategy are often exploited out of the market. This is what happened to the Dogs of the Dow, a popular strategy. Could smart beta be the next failure?

If you look at the risk premium from these strategies (net of the cost to do it), Ferri would argue it’s a lot lower than it was in, say, 1999. The risk premium could be zero or less for the next 15 years, Ferri believes. So if investors are going to get into the strategy now, you’d better stay in for the rest of your life because that’s how long it may take to reap the benefits from it.

Ferri sees three disadvantages to smart beta. First, “The cost of beta is basically free.” In other words, you can buy a Vanguard Total Stock Market ETF for 5 or 6 basis points, and get beta exposure that way. Anything other than beta—such as equal weight or fundamental weight strategies—is more costly. You can pay anywhere from 35 to 80 basis points for those, and most of that fee goes to the manager. “You automatically impart a hurdle rate on your portfolio.”

There’s always more risk with smart beta, he said. Nobel Prize winner Eugene Fama told Ferri, “There’s no such thing as a smart beta. There’s no such thing as alternative betas. What there are, are additional betas, because you have to think of beta as a risk.” Smart beta strategies, in other words, are throwing additional beta into the mix, and that means more risk.

Lastly, there are long periods of time where these strategies underperform the market. Small-cap value, for example, underperformed from 1983 to 2001, Ferri said. “Are your clients going to hang in there for 18 periods of underperformance? The answer is, probably not.”